Fitch: Mixed Outlook For CDO Performance in 2006.

LONDON & NEW YORK -- Fitch Ratings expects CDO performance in 2006 to be mixed, with some sectors continuing to exhibit the strong performance seen in 2005, with other sectors expected to deteriorate, typically driven by Fitch's view of performance of the underlying asset class.

The year ahead is likely to hold specific challenges for the performance of global corporate credit, which forms the underlying collateral of investment-grade synthetic CDOs and CLOs. On the one hand, whilst investment grade corporate synthetic CDOs have performed well in recent years, owing to the small number of credit events occurring in 2003-04, the Delphi credit event in October 2005 may herald an uptick in credit events from weakening names, primarily in the automotive sector. The high level of leverage inherent in this CDO sub-sector does leave CDO tranches exposed to widespread negative rating action should further credit events be called on widely-referenced names. On the other hand, for CLOs, whilst increasing loan leverage may well contribute to an increasing default rate on the underlying assets in the coming year, CLO tranches are expected to be resilient, owing to a combination of factors; a starting point of base default rates well below historical and expected levels, higher than expected recoveries observed in some large recent defaults may continue, and the benefits of deleveraging for those CLOs that are at the end of their reinvestment periods.

US CDO sectors are expected to produce mixed ratings performance with ratings and credit quality improving in both Commercial Real Estate CDOs and TruPs CDOs while mixed in US Structured Finance (SF) CDOs. Within the diverse US SF CDO sector, High Grade ABS CDOs are expected to be the most stable, recent vintage mezzanine SF CDOs are also expected to be stable though they are highly dependent on sub-prime RMBS collateral performance where high prepayments and strong loss performance to date are expected to offset the impact of higher rates and slower home price growth. Early vintage mezzanine SF CDOs are expected to continue to deteriorate owing primarily to Manufactured Housing exposure.

ABS CDOs in Europe, unlike in the US, tend not to have exposure to higher-yielding ABS sectors facing performance challenges, such as US Home Equity loans. The underlying ABS sectors are expecting stable to improving performance, which will contribute to continued stability of European ABS CDOs.

European SME CDOs are expected to exhibit positive rating performance, due to high prepayment rates and amortising structures. Performance is further bolstered on Spanish deals by very positive underlying loan performance. In Germany, the loan performance has been somewhat less positive, but it is expected to stabilize, and the transaction structural features have resulted in positive CDO performance despite less-than-stellar loan performance.

Whilst Fitch anticipates CDO performance being mixed, it expects to see ongoing innovation of new structures, which was so evident in 2005. As the synthetic and cash CDO markets continue to converge, the traditional cash CDO market is also undergoing a metamorphosis with the emergence of unrated collateral in commercial real estate CDOs.

As traditional cash CDO investors grow more comfortable with the increased use of derivative instruments, hybrid and managed synthetic transactions are also expected to gain traction, even more so with the launch of the International Swaps and Derivatives Association's (ISDA) settlement and documentation procedures for credit default swaps, referencing asset-backed securities (CDS on ABS).

Buckets for synthetic securities in structured finance CDOs doubled in 2005 to 50% from 25% the year before. Fitch has started rating a number of hybrid CDOs this year, most of which reference residential mortgage-backed securities (RMBS), but upcoming transactions will reference a wider array of asset classes. The deal sizes are expected to get larger because hybrid CDOs tend to have shorter ramp-up periods. CDO managers are attracted to these structures because it allows them to take advantage of pricing opportunities in both the cash and synthetic arenas.

Separately, the entry of managed synthetic CDOs has put managers' role in the spotlight, and has prompted the need for increased surveillance of managers' capabilities as these portfolios become more complex. Questions such as how aligned managers' interests are with investors, and how much trading flexibility they should have, are cropping up and will continue to be among the hot talking points in 2006.

Fitch's 'Global Structured Finance: 2006 Outlook and 2005 Review' includes asset performance and rating volatility forecasts for the global ABS, CMBS, RMBS and CDOs sectors in 2006, along with how broader macroeconomic trends will influence the structured finance markets in the U.S. and overseas, and an overview of rating performance and credit migration trends over the past year. The report is available on the Fitch Ratings web site at www.fitchratings.com.

Fitch Alert Surveillance Tracker (FASTracker), is a web-based portfolio management tool that allows investors to actively monitor through customized alerts how new research and other performance data are affecting bonds in the ABS, CMBS, RMBS and CDO sectors. To learn more about FASTracker, contact Fitch's sales department in New York at '[e-mail]' or 212-908-0800; in Europe, please contact Elizabeth McGlogan at '[e-mail]' or [phone]; in Asia, please contact client services at '[e-mail]', or [phone].

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